Increased government spending will reduce long-run growth rate of real GDP if : a. the government...

Increased government spending will reduce long-run growth rate of real GDP if :

a. the government spending involves building dams and levees.

b. the private spending that is crowded out is investment spending.

c. the private spending that is crowded out is consumption spending.

d. the government spending involves increased spending on highways and bridges.

Expert Solution

Increased government spending will reduce the long-run growth rate of real GDP if the private spending that is crowded out is investment spending. This is because when government spending is increased the income level in the economy rises. For a given level of money supply increase in the income raises the transaction demand for money. As a result, people will start to withdraw money from their speculative balances to finance their transaction needs. To keep the money market in equilibrium the interest rate needs to rise. On the other side, to finance their increased spending the government borrows from the market by selling its securities. To make people buy its securities the government needs to offer higher interest rate and lower securities' prices.

The increased interest rate will result in the decline in investment as firms will find it expensive to borrow for plants and machinery. So, in the long-run, the increased income levels due to government spending will be negated by the decline in investment spending due to increased interest rates.

Rahul Sunny answered 2 years ago

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